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According to the Fed's Bullard, one of the reasons for the US central bank to cut rates is the more pronounced yield curve inversion which historically signals that the risk of a recession is increasing. Since last November, part of the US yield curve has been inverting, but not yet the most common indicator watched by investors, the two-year/10-year spread, which currently stands at 0.25%. However, based on most research papers published by the Fed, investors should rather look at the one-year/10-year spread as it has the best track record to predict likelihood of recession.
Recent developments tend to confirm the bears’ worst fears. The one-year/10-year spread briefly inverted in March of this year for the first time since the Great Financial Crisis. Then, the curve steepened before going back into contraction last month as concerns about the global slowdown and the trade war intensify. It is not unusual that the curve rebounds slightly before inverting again. The same happened prior to the last US recession. The first inversion took place in January 2006, then the curve went back into positive territory until June 2006, when the second inversion happened. Seventeen months later, the US officially entered recession.
Based on the past seven decades, the lag between the inversion of the yield curve and the start of the recession is on average 22 months. In terms of monetary policy, an inverted yield curve has deep implications as it led all of the past six Fed easing cycles of the past three decades and, considering recent market expectations regarding cut rates, it is likely to lead the seventh Fed easing cycle as well.
While we are talking a lot about the inverted yield curve, this phenomenon gives us little information. It does not tell us exactly how long before the recession starts, its length, and what will be the stock market behaviour during the pre-recession period and during the recession. It only confirms that we are at the very late stage of the business cycle and that investors should be prepared to make their portfolios more defensive.